Background

The state levies a personal income tax (PIT) on the
income of individuals and noncorporate businesses, such as sole proprietors and
partnerships, doing business in California. The rates of the tax range from
1 percent to 9.3 percent, depending upon the taxpayer’s income level (with an
extra 1 percent levied on taxpayers’ incomes greater than $1 million). The state
also levies a corporation tax (CT) on the net earnings of corporations operating
within California at the rate of 8.84 percent. Both the PIT and CT allow various
deductions from income and credits against any tax owed. The state also levies
an estate tax payable upon death, equal to the amount of the available state tax
credit allowed under the federal estate tax (this credit is currently zero).
Finally, residential and commercial property is subject to a general-purpose
local ad valorem property tax rate of up to 1 percent annually.

Provisions of the Initiative

This measure contains the following main provisions:

Establishes a Wealth Tax. The measure
institutes a state wealth tax levied on those estates of living individuals with
values in excess of $20 million as of January 1, 2006. The wealth tax would be
based on the tax rates established by the federal estate tax, which in calendar
year 2006 are scheduled to range from 18 percent to 46 percent. It appears that
the wealth tax would be levied on taxpayers in the state on a one-time basis,
with revenues to be received in 2007‑08 and 2008‑09.

Alters Income Tax Rates. The measure
reduces the CT rate from 8.84 percent to 4 percent, reduces the CT minimum tax,
and enacts various other changes to the CT. In addition, it imposes a 6 percent
additional tax under the PIT for high-income taxpayers. It also eliminates the
current alternative minimum tax for both the PIT and the CT.

Curtails Certain Tax Expenditures. The
measure eliminates or restricts certain so-called tax expenditure programs
(TEPs). These TEPs are various provisions of the tax code such as tax credits,
income deductions, and income exclusions that reduce the amount of revenues the
state collects. Among the most significant of the TEPs that would be eliminated
or restricted are: (1) personal and dependent exemption credits, (2) enterprise
zone deductions and credits, and (3) research and development activity credits.

Institutes New Tax Programs. The measure
establishes several new tax programs including tax credits for: (1) certain
taxpayers with a federal estate tax liability, (2) income earned by teachers,
(3) higher education tuition and fees, (4) rents foregone by property owners due
to rent control, (5) property tax payments, (6) the costs of purchasing health
insurance for certain individuals, and (7) particular designated organizations.
A number of these credits would be refundable.

Fiscal Effects of the Initiative

This measure would make major changes in the state’s tax
system. Some of these proposals would generate significant behavioral and
economic responses from taxpayers. For example, a wealth tax of the magnitude
imposed by the measure would result in a significant decline in state wealth in
the short term. Such a development would depress economic activity and revenues
to the state and local governments. Given factors such as this, the fiscal
estimates provided below are subject to considerable uncertainty.

State Revenues

One-Time Revenue Increases. The measure
would result in a one-time increase in state revenues (realized in 2007-08 and
2008-09) as a result of the establishment of the wealth tax. The increase could
be in excess of $100 billion.

Ongoing Revenue Impact. The increase in the
top PIT rate, the elimination or restriction of various TEPs, and certain other
changes to the state’s tax system would together result in additional combined
revenues in the range of $10 billion to $20 billion dollars annually. Offsetting
these additional revenues would be reductions associated with various TEP
provisions and the CT rate reduction. The largest of these reductions involve
the proposed teacher tax credit, health insurance tax credit, and CT rate
reduction. These and other provisions would reduce state revenues (or result in
increased expenditures in the case of refundable credits in excess of tax
liabilities) in the low tens of billions of dollars annually. The net impact of
all of the ongoing revenue provisions would be annual revenue decreases
potentially in excess of $10 billion annually.

Impacts Related to Revenue Increases

The measure’s major one-time revenue effects would lead
to significant interactions with other State Constitutional provisions,
particularly regarding the state’s spending limit and school funding.

Spending Limit. While state spending is
currently subject to an annual limit on appropriations of tax revenues, the
state is currently far below—about $11 billion—its limit. As a result, the state
could spend some portion of the large influx of new tax revenues estimated under
the measure in 2007-08 and 2008-09. In addition, the state could spend some of
the remaining funds on appropriations not subject to the limit (such as
debt service on outstanding obligations and capital outlay). Still, the state
would likely have remaining a large amount of “excess revenues,” which existing
law requires to be allocated as follows:

One-half to schools and community colleges.

One-half to tax rebates.

These could each exceed
$10 billion in 2007-08 and again in 2008-09.

Proposition 98. Proposition 98 consists of
specific funding formulas for K-12 school districts and community colleges (K-14
education). The level of and changes to General Fund revenues are important
factors in determining school funding under Proposition 98. The large one-time
revenue increases generated by this initiative in 2007-08 and 2008-09 would
result in additional school funding potentially in excess of $10 billion dollars
annually for those two years. Thereafter, the net reduction in annual revenues
would substantially lower the required funding level for K-14 education,
potentially by billions of dollars. Actual school funding would be determined by
future legislative decisions in dealing with the major reduction in ongoing
revenues.

Summary of Fiscal Effects

The measure would have the following major fiscal
effects:

One-time increase in state revenues potentially
exceeding $100 billion from imposition of a wealth tax. A portion of this
revenue would be required to be allocated to schools with the remainder used
for other state spending or tax rebates.